The IRS Strikes Down Another Research Credit Claim

On December 23, 2024, the U.S. Tax Court delivered an unfavorable opinion against an engineering firm claiming the research tax credit in Phoenix Design Group, Inc. v. Commissioner (T.C. Memo. 2024-113). Ultimately, the IRS denied the taxpayer’s claims of uncertainty. The court found that the firm’s research activities did not meet the criteria for qualified research, resulting in additional liability for accuracy-related penalties.

Phoenix Design Group, Inc. (PDG) is a multidisciplinary professional engineering firm focused on designing mechanical, electrical, plumbing and fire protection systems (MEPF) in hospitals and laboratories. The company engaged the alliantgroup to perform a research credit study for the tax years 2012 through 2016. Alliantgroup ultimately identified 238 projects that could potentially involve qualified research activities.

Due to the large number of projects included in the claim, both PDG and the IRS agreed to limit the review to a sample of three projects. The parties further agreed — should the court hold that no qualified research existed within any of the three projects, then PDG would be subject to accuracy related penalties. However, the court clarified that its holding was solely applicable to the three selected projects and would not be binding on the remainder of the projects claimed.

Understanding the IRS’ Two-Step Test for Research Credits

In evaluating the three selected projects, the court applied the following two-step test to determine whether PDG’s activities constituted research and development for purposes of the research credit:

1. The taxpayer must show that the information objectively available did not establish the capability, method or appropriateness of design.
2. The taxpayer must then demonstrate that it undertook investigative activities intended to discover information to eliminate that uncertainty.

Why the Court Denied the Claim

For each of the three selected projects, PDG was contracted by an architect to design a MEPF system for a hospital. PDG asserted that uncertainty existed as to the appropriate design of each MEPF system and that the uncertainty existed because of the possibility of revising the design of the MEPF system before construction was complete. The court held that PDG failed to demonstrate the interrelated nature of the various components of the MEPF systems, where uncertainty in one portion of the system would create uncertainty with respect to the entire MEPF design. The court held that uncertainty in one subcomponent does not necessarily render the entire business component uncertain.

Because PDG and the IRS stipulated that both the permitted purpose and technical in nature tests were met, the court focused its review on the technical uncertainty and process of experimentation tests. The court held that PDG failed to identify that specific information was not available to the PDG engineers. This caused uncertainty at the outset of the project or the subsequent investigative activities the PDG engineers undertook to resolve that uncertainty. PDG simply presented issues that the engineers encountered and the resulting design decisions based on those facts. The court stated that performing calculations on available data is not an investigative activity because PDG already had all the information necessary to address that uncertainty. For example, the court found that performing calculations to determine duct size based on airflow was not an investigative activity.

Key Takeaways for Businesses Claiming the Research Tax Credit

This case is yet another taxpayer-unfavorable holding among a recent trend of cases challenging tax research credit claims, particularly within the engineering and construction industry. This holding further signifies the importance that taxpayers need to clearly document the uncertainties at the outset and the challenges encountered, but just as importantly, document the method in which they overcame them. The court continuously referred to the lack of demonstrated investigative activities as a requirement to satisfy the process of experimentation test. Much like in academia, it is insufficient to simply present the issue and the solution. One of the primary criteria for claiming and sustaining the research credit is to clearly document the process engaged in to evaluate one or more alternatives to arrive at the most optimal solution.

Strengthening Your Research Credit Claims

Taxpayers are advised to seek professional guidance from reputable tax advisors to ensure a systematic process of experimentation to resolve the technical uncertainties encountered at the outset is sufficiently documented. Contact us to discuss the research tax credit and your business with Weaver’s team. Our tax professionals are here to help.

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